Has Brazil’s equity rally run out of steam?

Is it time to sell Brazil? Yes, according to the Swiss bank that accurately called the strong rally in equity and FX during the past 12 months.

Credit Suisse and its Swiss competitor UBS have been eyeing the strong equity valuation and FX performance of Brazilian equities and looking to time a withdrawal. And after a 33% US dollar outperformance since moving overweight on Brazilian equities one year previously (March 8, 2016), Credit Suisse is moving underweight Brazil – and allocating those gains to a 10% overweight call on Malaysia.

Since Credit Suisse’s – then contrarian call – into Brazil, the MSCI Brazil index has appreciated by 56% in US dollar terms and 29% in local currency, outperforming the MSCI emerging market (EM) benchmark by 33%.

Alexander Redman, analyst with Credit Suisse in London, notes the market has moved the bank’s way in the past year. In a report called ‘Taking profits after a year overweight Brazil’, he points out that at the time the bank moved overweight Brazil, the median positioning of dedicated EM equity funds was 5% below the benchmark for Brazil. That position has now switched to 6% overweight.

Also pointing to a certain frothiness is the statistic that March 2016 marked the lowest point of analyst sentiment on Brazil, with 18% more sell and hold recommendations than buy calls – the most depressed sell-side view for a decade. In January 2017, the number of buy recommendations increased to the point where they outnumbered holds and sells for the first time since July 2014.

“All that is left is momentum and wishful thinking,” argues Redman. “A year [after the move to overweight Brazil] investor sentiment towards Brazil has recorded a volte-face. EM equity fund positioning is now the highest relative to the benchmark since 2008.”

Redman says Brazil’s currency has now moved to be the second most- expensive EM currency – posing a threat for dollar-denominated returns, especially as the bank argues that external dynamics will become less supportive of the currency in 2017 and 2018 due to its external financing needs. Also, although GDP growth is also forecast to return to positive territory this year, it is expected to be more in line with the 1981 to 2003 period of between 2.2% rather than the 4.4% seen between 2004 and 2011 – due mainly to demographic factors, low productivity and no uplift for commodities.

Redman points to the fact two-thirds of the 48 percentage point cumulative gain in Brazilian GDP since president Luiz Inácio Lula da Silva’s election in 2002 was due to gains in the workforce, with only the remaining third the result of demographics. This demographic boost is now running out – and will turn negative in 2020.

“Reform is critical to Brazil’s growth trajectory, most importantly addressing two key bottlenecks in the economy,” writes Redman.

“First by increasing labour market flexibility as a measure to boost productivity and hence competiveness. Second, the removal of inflation indexation of public sector wages and other administered prices, which would structurally lower inflation, bond yields and hence the corporate cost of capital, and boost equity value creation.”

Aptly, Redman’s call to go underweight Brazil came on the day that the country saw widespread protests to its proposed pension reform and one day after leading politicians – including five ministers – were named in the latest phase of the Lava Jato corruption enquiry. Both suggest a path to deep reforms will be problematic.

Redman’s strategic switch away from Brazilian equities in the financial space is based on the analysis of his financial analyst colleague Marcelo Telles. Telles says the expectations of a gradual improvement in bank asset quality and lower provisioning levels “is widely shared by management teams … and thus we believe is already reflected in asset prices” and the next couple of years will be characterized by limited credit expansion as households concentrate on “measured repair” of their finances – creating little room for outperformance by the banks.

Meanwhile, UBS has also been pondering whether Brazilian banks still offer value. In its client report ‘Is it time to sell Brazilian banks’, UBS points out that “we have seen a major valuation re-rating in Brazilian banks, from 6.0x PE to 10.0 PE as the sector’s cost of equity declined given political changes and prospects of structural reforms.”

However, while the report concludes that “there is limited scope for multiples to expand further [and] we now need to see positive earnings revision to support share prices or risk seeing a reversal in sector performance”, the bank maintains its neutral stance on the sector.

One investor says the valuations of Brazil’s financial sector are finely balanced and cause for caution. On one hand, the Ibovespa’s financial sector is trading slightly above its long-term average – at 10.6-times forward PE versus its historical average of 9.5 times – which suggests room for future outperformance is limited.

However, despite the recent valuation rally, banks on the Bovespa are still trading at around 11% discount to the MSCI Brazil and – bar a few exceptions – a feature of the market has been that the banks tend to trade above the overall market.

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